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January 8, 2013

Eight Hedge Fund Trends in 2013

Agecroft Partners predicts record fund assets

The hedge fund industry will set a record for assets this year despite the sector’s lackluster investment performance over the past two years, according to predictions by Agecroft Partners, a global consulting and third-party marketing firm for hedge funds.

Agecroft based this conclusion on several dominant and emerging trends it identified through its contact with more than 2,000 institutional investors and 300 hedge fund organizations during 2012.

1. Pension funds will drive growth in the hedge fund industry in 2013

As many pension funds face massive unfunded liabilities, they will continue to increase their allocation to hedge funds in order to enhance returns and reduce downside liabilities, Agecroft predicts. Forward-looking return assumptions are currently around 3% for fixed-income portfolios managed against the Barclays Aggregate Bond Index, which currently represents approximately 30% of pension funds’ total assets. With current actuarial return assumptions averaging approximately 7.5%, pension funds will shift more assets from fixed income into hedge funds as long as interest rates stay low.

Actuarial pressures are forcing some bigger pension funds to accelerate their hedge fund investment process. Pensions used to tiptoe into hedge funds, taking a decade or longer. They would start with an investment in a fund of funds, followed by hiring a consultant and investing in brand name managers. As their experience increased, the process would move in house, with internal teams making independent decisions and focusing on “alpha generators.” Finally, the process would evolve into a best-in-breed strategy of investing, with hedge funds no longer considered a separate assets class, but incorporated throughout the portfolio.

Time is now a luxury, and some bigger pensions are skipping the fund-of-funds roundabout and investing directly in individual managers. This, in turn, has long-term implications for funds of funds.

3. Funds-of-hedge-funds industry continues to evolve

The FoHF marketplace is approximately 25% smaller than at its peak in the third quarter of 2008, and fee income has declined by more than 50%, owing to downward pressure from large institutional investors. Agecroft predicts that in 2013, FoHFs will experience slight net redemptions as withdrawals by the largest pension funds choosing to invest directly in hedge funds will be partially offset by smaller institutional investors increasing their allocations to funds of funds and new high-net-worth individuals entering the space.

Agecroft also looks for further bifurcation in the FoHF sector, with a few firms growing their asset base and others experiencing large net redemptions. The successful organizations will include large multistrategy funds of funds with strong performance that can justify their fees by clearly articulating their competitive advantage over hedge fund consulting firms, and niche FoHFs that differentiate themselves by focusing on a specific strategy, region, fund structure or investor type.

4. Passage of JOBS Act will change hedge fund marketing strategies

The JOBS Act will help level the playing field within the hedge fund industry by giving investors greater transparency, according to Agecroft. Many hedge fund websites will provide detailed information on their organization, investment team, investment process, risk controls, performance and service providers. More managers will participate in industry databases, making it easier for investors to identify and compare managers within a strategy. Investors will also benefit from more hedge fund managers being interviewed in the media about their hedge fund strategies and investment ideas.

Agecroft predicts that the increased transparency will benefit the hedge fund industry by broadening the investor base and increasing net asset inflows.

5. Rise of long/short equity

Agecroft expects to see more assets allocated to long/short equity in 2013. At the turn of this century, l/s equity managers claimed more than 40% of hedge fund industry assets. Since 2008, a significant amount of those assets have been reallocated to other hedge fund strategies, causing total assets in the strategy to decline to approximately 25% of the industry. This decline has been driven by a combination of poor performance and of investors increasing allocations to strategies uncorrelated with long-only equity and fixed income benchmarks and to strategies with better perceived relative valuations of their underlying securities.

Agecroft says these last two trends should begin to reverse because relative valuations of equities based on price/earnings ratios look very attractive compared with fixed income. In addition, at some point fundamentals will drive stock valuations, which should significantly benefit l/s equity managers.

6. Lines between hedge funds and private equity funds blur

In 2008, the main difference between hedge funds and private equity funds was the structure of the fund and often not the liquidity of the underlining investments. Many hedge funds that focused on illiquid fixed income instruments offered their investors monthly liquidity. As the financial crisis erupted, this created significant liquidity mismatches for many hedge funds, prompting them to impose gates, suspend redemptions or liquidate. Today many sophisticated investors understand the benefits of illiquid investments, but are demanding fund liquidity provisions that match the underlying liquidity of the portfolio. Agecroft expects longer lockups, longer redemption notice periods, gates and private equity structures for illiquid strategies.

7. Continued concentration of hedge fund flows

The hedge fund industry is highly competitive, with some estimates as high as 10,000 funds in the marketplace. Agecroft predicts that in 2013, 5% of hedge funds will attract 80%–90% of net assets within the industry. The largest hedge funds, as well as some small and midsize ones, will rise above their peers by effectively raising significant assets. To do this they will need to excel in three areas:

Offering a high-quality product

Creating a marketing message that clearly and concisely articulates their differential advantage across all the evaluation factors investors use to select hedge funds

Developing a best-in-breed sales strategy by either building out an internal sales team or leveraging a leading third-party marketing firm, or a combination of both.

Firms that do not excel in each of these three areas will have a difficult time raising assets, Agecroft says.

8. More hedge funds focused on the retail market

As asset raising becomes increasingly difficult, more hedge funds will target the retail markets that are less competitive and easier to attract, Agecroft predicts. In Europe, assets in UCITS funds have expanded significantly with more growth expected in 2013, according to Agecroft. In the US, 40 Act hedge funds and FoHFs are experiencing fast growth, with many more expected to launch this year. As well, hedge fund replication strategies are using ETFs. Agecroft says all of these vehicles have both strengths and weaknesses and could create more regulatory scrutiny.